As a small business owner, one thing you’ll want to be aware of is how your income is treated by the IRS. Not knowing this from the start will only cause complications, headaches, and costly mistakes down the line. Here we’ll go over the difference between ordinary and unearned income, as well as what each means for your business tax-wise.
To help you get your head around these two main types of income, we talked with tax expert Mike Zeiter, CPA/PFS, financial planner and owner of Foundations Financial Planning.
Ordinary Income vs. Unearned Income
In the eyes of the IRS, there are two basic types of income:
1. Ordinary Income. Ordinary income is also called "earned income." As the name implies, earned (or ordinary) income is any money earned from your business activities or employment. It can come in the form of a salary, commissions, tips or bonuses gained by working for someone else. It can also be income earned from your own company.
2. Unearned Income. Also known as passive income, unearned income is income that doesn’t come from work or business activities. Such income can be generated through:
- Interest from savings accounts
- Rental income
- Stock dividends
- Real estate
- Retirement plans
- Lottery winnings
- Social Security
With passive or unearned income, the person receiving the income is not actively participating in how the money is being earned.
Ordinary Income Tax Implications for Your Business
If your small business is set up as an LLC, S Corp or C Corp, whether your income is ordinary or unearned will affect how you’ll be taxed.
Unearned Income and Your Business
Let’s say your business income is primarily from passive (or unearned) income, such as rental property or investment earnings. In that case, an LLC taxed as a partnership could be a good option, explains Zeiter. “It’s the easiest to set up, and if your business changes in the future, it could be an advantage to switch to an S Corp,” he notes.
Why is this? Because passive income and losses from an LLC or S Corp will flow through to the owner, and then be taxed at the owner’s normal tax rate. (If you do actually have a rental property, an LLC is a great way to protect your personal assets too!)
Ordinary Income and Your Business
If the income from your business is earned income, then there’s more to consider when trying to figure out the best corporate structure for your company, explains Zeiter. That's because earned income from an LLC or S Corp will be subject to self-employment tax. Also known as FICA, this is the 15.3 percent of your business’ net income that covers Social Security and Medicare taxes. (Because you’re self-employed, you’re responsible for covering both the employer and employee portion of these taxes.)
Passive income, on the other hand, is not subject to self-employment taxes. So if your business is set up as an LLC taxed as a partnership, all your earned income will be subject to this 15.3 percent tax.
Here’s where businesses set up as an S Corp can have a tax advantage: Because S Corps allow owners to pay themselves a reasonable salary, only the salary will be subject to the self-employment tax. The rest of the business income will pass through, and it won't be subject to this tax.
“Most businesses will not make a large enough profit in the first few years to take advantage of this S Corp benefit,” says Zeiter. So how much income would your business need to rake in? Generally, if your business earns more than $40,000, it could make financial sense to form an S Corp. “It varies depending on the company, but that’s a good starting point,” says Zeiter.
What About C Corps?
If your company is just starting out, Zeiter recommends not forming a C Corp for your new business just yet. "C Corps are complicated, and don't provide benefits for earned or unearned income because of double taxation rules," says Zeiter.
Double taxation means your company's profits will be taxed at both the corporate and personal levels. Before profits are distributed to shareholders, the business is required to pay income tax at the corporate rate. Then, dividends are also subject to the income tax rate — but at the individual rate of whoever is receiving profits from the dividends.
Still have questions about how to handle your ordinary or unearned income? We're here to help. Reach out to an Incfile today! Our incorporation experts can help you evaluate your options to understand which business structure is best for your company.